The Only Defense for Your Portfolio

Everything's falling at the same time.

You swore you'd be ready the next time the bottom fell out of the market. You'd have your defense planned, your next investments prepared, your watchlist well-stocked, and your bargains lined up.

So here's your chance. Are you ready?

Another big swoonYes, yesterday's 500-point drop in the Dow brought back memories of those days in late 2008 when what would later grow into the market meltdown was just beginning. Back then, it seemed like there was nowhere to hide; if you had just about any investment, it was down for the count.

This time around, things are much the same. Just take a look at the general carnage from yesterday:

All 10 sectors of the U.S. market dropped by at least 3%. Materials stocks got hit the hardest, falling almost 8% on the day.

International stocks didn't do any better. Both iShares MSCI EAFE and Vanguard MSCI Emerging Markets(NYSE: VWO) took huge hits, and they may get follow-through selling today as foreign markets catch up to the U.S. decline.

Even safe-havens like foreign currencies and commodities weren't immune from the selling. Gold gave up big gains to end down, and silver plunged. The Japanese government intervened to stop the yen from appreciating, and both it and most foreign currencies fell against the U.S. dollar.

What's more, among the hardest-hit stocks, you don't see any obvious trend. There were plenty of earnings-related problems, ranging from energy stocks Walter Energy(NYSE: WLT) and Western Refining(NYSE: WNR) to Dendreon's (Nasdaq: DNDN) big disappointment over its Provenge drug to Aeropostale(NYSE: ARO) and its nearly 25% plunge. Basically, companies from every sector took a hit.

The worst investment that went upAmid the devastation, the only investments that did extraordinarily well were bonds. Treasuries in particular saw immense gains, with short-term yields going pretty much to zero and long-term bonds rising 2.5% and more in price. That may not seem like much if you're familiar with the volatility of stocks, but a nearly three-point move for T-bonds is an amazing day.

Given that price action, you might think that Treasuries are the only defense for your portfolio. But before you jump in, think about what you commit to with a Treasury right now. Buy a 10-year Treasury today, and you'll pay about $1,060. In exchange, you'll get interest payments of not quite $16 every six months from now until 2021, and then you won't even get your $1,060 back, as the bond's par value is only $1,000.

In other words, you'll get $320 in total interest over 10 years, offset by a $60 capital loss at the end. You'll also get to pay taxes on that interest. And none of that takes into account the impact of falling purchasing power, which will make the $1,000 you get at the end worth closer to $750 even if inflation stays at 3% -- a bold assumption.

Your only real defenseWhat yesterday shows is that sometimes, the only way to reap long-term rewards is to suffer through short-term pain. In football, shutouts are very rare -- and in pro basketball, a winning team typically still gives up at least 80 points and often much more.

Similarly, you're not going to be able to avoid all the down days in the market. But by doing three things, you can make sure you'll get its long-term benefits:

Make sure you have all the liquid cash you'll need for a while. That frees your mind to worry less about your long-term investments and their value.

See it as an opportunity. Whether stocks go up or down tomorrow makes no difference if you have years or even decades to go before you need to draw cash from your portfolio. Stocks are a lot cheaper than they were last month, so take advantage.

Market downdrafts have happened before, and they'll happen again. Get comfortable with them, and you may even come to see them as a healthy part of a profitable investing strategy.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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